Perhaps you’ve been a property manager for quite some time and have accumulated several rental properties, or maybe you’re managing tenants in your first income property. In any case, you may have wondered whether you should form a corporate structure for your rental property.
As a landlord, you’re operating as a sole proprietor, which means there is essentially no divide between your rental income and your personal income. This may be fine if you don’t plan on expanding your rental investment portfolio, but if you ever run into legal issues, your personal assets could be at risk.
In this post, we’ll discuss the benefits and drawbacks of incorporating or forming an LLC for your rental business, and when it may or may not be the right choice for you.
What is Incorporation?
Incorporation means to turn your business into a corporation that separates your rental income from your personal income. As a separate entity, a corporation limits the liability of its owners so that in the event the corporation incurs debt or has legal troubles, the business owner is not held personally responsible.
To form a corporation for your income properties, you’ll need to file for incorporation with the government and transfer the title of these properties to your company with a Warranty Deed or Quitclaim Deed. Transferring the title of your properties to your business means that your business is now the owner, and you’re no longer personally liable.
What is an LLC?
An LLC (or limited liability company) is another legal business structure that landlords can use for their real estate investments.
LLCs are known for “pass-through taxation,” which means that the business doesn’t pay taxes; instead income is passed to the member(s) to report on their personal taxes (just like a sole proprietorship). Members must also pay self-employment tax, which corporations do not do.
However, LLCs are flexible in that you can submit a form to the IRS to be taxed as an S Corp or C Corp if your LLC has high earnings and you’d like to take advantage of corporate tax savings (though this a decision you should discuss with your financial advisor or accountant beforehand).
Like a corporation, an LLC helps to shield your personal assets or property from being seized if you run into debt or tenant legal issues. LLCs also allow for a property to be distributed easily after you’ve passed away; beneficiaries simply receive a certificate to illustrate their stake in the property.
To form an LLC, you must pay filing costs, which are similar to the cost of incorporation, and transfer your real estate to the LLC. You will also have to decide whether you wish to form an LLC for each property or have a single one for all your properties. Multiple LLCs help to keep your liability separate between properties, so that if a tenant is injured at one location, they cannot put a claim on another property. Also, banks usually prefer a separate LLC for each property to ensure that one property will not negatively impact the other that they are lending on.
Some people prefer the flexibility of an LLC because taxation remains the same, and you may be eligible for several of the same deductions.
Benefits of Incorporating or Forming an LLC
Like mentioned above, incorporating or forming an LLC for your properties can provide tax perks and protection against liability.
Collecting rental income from your properties puts you into a higher tax bracket. When you incorporate your rental property, you are separating your rental income from your personal income, which can lower your individual tax bracket. On the business side of things, you become eligible for business tax deductions, including business expenses and medical insurance.
A major benefit of both incorporating or forming an LLC as a landlord is the limited liability. When you’re working as a sole proprietor, you are responsible for any debt or issues that arise with your property. After you’ve incorporated or moved your properties into an LLC, the business is now responsible for any obligations or problems that arise.
Drawbacks to Incorporating or Forming an LLC
Although forming a corporation or LLC can protect your personal funds, there are more responsibilities involved with running a corporation or LLC as opposed to a sole proprietorship.
First, it can cost hundreds of dollars to form a corporation or LLC in your state, including the recurring expenses that some states require for these structures.
With a corporation, your paperwork will increase because you must keep records of meetings. You’ll also have to file both personal taxes and corporate taxes.
How you file your LLC taxes depends on how many members there are in your company. Single-member LLCs only require one tax return, whereas multiple-member LLCs require a separate partnership tax return.
If you decide to form an LLC for your rentals, it’s important that you keep your personal and business finances separate to avoid losing liability protection. In other words, don’t pay for rental repairs with a personal check or use a shared bank account for business expenses.
Another consideration before forming either structure is how this change would impact your day-to-day landlord business. For instance, in some states after forming an LLC, you’ll need an attorney to represent you in court during an eviction proceeding.
Transferring Title With a Mortgage
If your income property still has a mortgage and you’d like to transfer it to an LLC or corporation for liability purposes, consult with your bank or lender to discuss your options. Check to see if there is a “due-on-sale” clause in your mortgage. This can require you to pay out the remainder of your mortgage to move it into an LLC. Banks see this transfer of property as a sale and can request that you pay the balance. Always speak to your lender before making the decision to form an LLC or corporation for your properties.
Other Ways to Limit Your Liability
Forming a corporation or LLC both help to limit a landlord’s personal liability in their rental property, but there are a few other options as well.
Landlord Insurance: Landlord liability insurance can help to protect your assets should a tenant ever get injured on the property and try to sue you. Umbrella insurance policies add an extra layer of protection and cover an array of liabilities including vandalism, flood, and fire damage.
Note that a landlord can be liable if a tenant is injured as a result of neglect, such as failing to clear walkways or repair a stairwell. This is important to remember, as it does not make forming an LLC or corporation a concrete form of liability protection.
Trust: By placing your rental properties in a revocable trust, you can lower your personal risk while also lessening your estate tax for your beneficiaries.
Protecting Your Assets
Before transferring your property to a corporation or LLC, it’s important to learn more about what each of these structures involve in terms of responsibility and cost.
An LLC is a popular option for achieving liability protection and flexible taxation. Corporations achieve the same goals of limiting liability, and also separate your personal and business assets.
While none of these options are bulletproof, putting your rental investments into an LLC or corporation can help to lower your risk of bankruptcy. As a landlord, you should try to minimize your risks where it makes sense to do so, while also protecting your property through a comprehensive insurance policy.
Have you formed an LLC or corporation for your rental properties? Would you?